Episode 59 – Strategies for a Market in Turmoil, with guest Charlie Smith

Episode: 59
Originally Aired: August 17, 2011
Topic: Strategies for a Market in Turmoil, with guest Charlie Smith

The Lange Money Hour - Where Smart Money Talks

The Lange Money Hour: Where Smart Money Talks
James Lange, CPA/Attorney
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  1. Introduction of Money Manager Charlie Smith of Fort Pitt Capital
  2. S&P Worried That Politicians Lack Will to Reduce Spending
  3. This Is the Wrong Time to Change Investment Behavior
  4. Money Manager Keeps Scared Investors From Being Stupid
  5. It’s Smart to Go Shopping While Things Are on Sale
  6. Computers and Robots Dominate Trading During News Events
  7. Collapse Like Lehman Brothers Isn’t Likely Unless Europe Stumbles
  8. Over Time, Stocks Will Outperform Bonds
  9. What’s a Business Worth, and What’s the Future of Its Industry?
  10. Young Gold Is Not an Investment, It’s a Hedge Against Hyper-Inflation
  11. Social Security, Pension Benefits Make Up Fixed Income Portfolio
  12. To Offset Gains, Search Portfolio to Balance With Losses

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Welcome to The Lange Money Hour: Where Smart Money Talks with expert advice from Jim Lange, Pittsburgh-based CPA, attorney, and retirement and estate planning expert. Jim is also the author of Retire Secure! Pay Taxes Later. To find out more about his book, his practice, Lange Financial Group, and how to secure Jim as a speaker for your next event, visit his website at paytaxeslater.com. Now get ready to talk smart money.

1. Introduction of Money Manager Charlie Smith of Fort Pitt Capital

Hana Haatainen-Caye:  Hello, and welcome to The Lange Money Hour, Where Smart Money Talks.  I’m your host, Hana Haatainen-Caye, and, of course, I’m here with Jim Lange, CPA-attorney, and best-selling author of the first and second editions of Retire Secure! and now his new book, The Roth Revolution: Pay Taxes Once and Never Again.  Jim’s books have been endorsed by Charles Schwab, Larry King, Ed Slott, Roger Ibbotson, Jane Bryant Quinn and dozens of additional financial experts.  Jim has been quoted thirty times in the Wall Street Journal.  Jim is the president of a CPA firm that prepares tax returns, a law firm that drafts wills and trusts and a registered investment advisory firm that provides investment services for cutting edge retirement and estate planning strategies.  Tonight, Jim is joined by Charlie Smith, co-founder and chief investment officer at Fort Pitt Capital.  Charlie is one of the area’s most respected money managers.  Good evening, Jim.

Jim Lange:  Thank you.  I should also tell listeners that I am not independent of Charlie Smith and Fort Pitt Capital Group.  Charlie and Fort Pitt Capital Group manage my and my wife’s investments, and we have a business arrangement whereby if you use the combination of our firm, which is the Lange Financial Group, and Fort Pitt Capital Group, we do the strategic work such as Roth IRA advice, distribution advice, retirement advice, estate planning advice, et cetera and Fort Pitt Capital does the actual investing, and together, we charge either 1 percent or less of the assets that are invested.  So, I do want to say that I am not independent with Charlie, but obviously, I have a great respect for him and that’s where my own money is.

So, Charlie, maybe you can help us try to get a picture of what happened.  I was thinking, you know, finally we have a debt ceiling agreement, and certainly the markets will respond favorably because we didn’t know if we were going to have it, and then instead of all good things happening to the market, we experienced big drops and then some ups and then some more drops.  What’s going on?

Charlie Smith:  Well, I think the backdrop to the debt ceiling fiasco, and there really isn’t a better word for it than that, was that S&P had said back on, I believe, July 17,  that unless as part of the debt ceiling deal we saw a long-term, the prospect of over the next 10 years, the prospect of reducing debt by up to $4 trillion, that S&P was going to act, and they were going to act in terms of a downgrade on U.S. debt.  So, the fact that we were able to come to a last second agreement on the debt ceiling itself really didn’t satisfy the minions at S&P.  So, that was sort of the sword of Damocles.  It was hanging over the market, and the retail investors pretty much believed that once we got the debt ceiling passed that we were in the clear.  Well, we had this issue hanging with us, and it wasn’t long after the debt ceiling deal was passed that S&P sort of said, “Well, that’s not enough, guys.  We’re going to downgrade you anyway.”  So, that really is sort of the backdrop to it.

Jim Lange:  Out of curiosity, and maybe it’s not relevant, but do you agree with the S&P’s assessment?


2. S&P Worried That Politicians Lack Will to Reduce Spending

Charlie Smith:  In terms of the economic fundamentals of the U.S. economy and the asset base of the U.S. government, I believe that a downgrade is not necessarily warranted, but in terms of the spending trends and the deficit trends, in terms of federal spending now running at 24 percent of GDP and revenues running at 15 percent, say, that gap steadily widening prospectively over the next 10 years, I think it was justified.  There was never any risk that interest payments would not have been made on U.S. debt because, basically, the Constitution says that debt holders will be paid first.  So, there wasn’t a risk that interest payments weren’t going to be made, and also, really, if we get down to the nub of it, the U.S. government can begin to sell off assets to make good on its debts.  Now, politically, that’s an impossibility, but in terms of the technicalities of the matter, the U.S. government has the ability to begin selling off land, selling off rights to minerals.  It really has a tremendous treasure trove of assets which it could begin to liquidate to begin to pay these debts.  Now, politically, I think that would take some steps that probably aren’t real likely, but the point is the U.S. has the capacity to pay its debts.  S&P was saying more about the lack of political will to reign in the spending so that this problem doesn’t continue to come up and repeat itself.  I think that’s more what S&P was saying than anything else.

Jim Lange:  All right.  And so, what is the implication for the investor who … and by the way, I remember at our appreciation dinner, you had some serious misgivings about the market, and obviously, you were right, but what does that mean for the investor now because he has seen his investments go down substantially, then come back up for a little air, and then maybe back down again?

Charlie Smith:  Well, let’s talk about what we mean by “substantial.”  We’ve seen approximately a 15 percent decline from the highs at the bottom back on August 5th or 6th, I guess it was.  We tend to believe that unless you’re able to withstand pretty much a 20 percent decline in the market value of your investments in any given year, you really aren’t necessarily cut out to be an investor.  So, I don’t view the decline that we’ve seen since, I guess, July 25th was the peak, I don’t believe that’s necessarily all that much of a big deal, so to speak.  The market’s come to define a correction as anything more that 10 percent and a bear market as anything more than a 20 percent decline.  We’re ready in our portfolios for as much as a 20 percent decline in any given year, and we don’t necessarily expect it, but we’re ready for it.  So, I don’t necessarily think that this decline is one that’s all that earth-shattering.

Now, if it gets combined with a significant downtrend in GDP and we do go into recession and we see further declines on the order of another 15 percent or 20 percent, that’s when it gets to the point where it starts to affect people’s behavior and the general public’s investing behavior, and that’s when the nervousness meter really spikes.

Jim Lange:  Well, let’s assume that you are an appropriate person to have at least a portion, and maybe a substantial portion, of your money in the market, and let’s assume that you can even withstand a 20 percent hit and you’ve taken it and you want to say, “Well, I should just be calm,” but you’re really thinking, “Oh my goodness.  Congress can’t get this together.  Europe’s falling apart.  Greece is going bankrupt.  The Middle East is about to explode.”  And you read in the paper, and then let’s say that you don’t like some of the political things going on, both with the presidential race and with Congress, and you’re thinking, “Oh man!  This is just going to go to nothing!  Maybe I should get into cash?  Maybe I should get into gold?  Maybe I should just get into other currencies?”  How would you respond to somebody who … and I’m sure a lot of people have that, even if it’s not at the front of their mind, but at least in the back of their mind.  I can’t tell you I haven’t thought, “Gee, I wonder, is there something that is a viable alternative to traditional stocks and bonds?”


3. This Is the Wrong Time to Change Investment Behavior

Charlie Smith:  For all the people who have that thought in the back of the mind, as you said that you might, you need to think in terms of planning ahead so that if that sort of thinking is going to potentially cause you to change your behavior at what is going to be exactly the wrong time, then you need to rethink your portfolio right now regardless of where the stock market is.  If you believe that a 15 percent or 20 percent decline, or the sum total of all these potential fears that you’ve put together, is going to cause you at exactly the wrong time to change, then maybe you need to change your portfolio now, because the idea that all of these various negatives can come together to create sort of a perfect storm is one that, as an investor, you always have to be prepared for.  So, here’s a way we do it in practical terms with our investors.  Any money that you’re going to need potentially from your portfolio within the next three years in cash should be in cash now.  That’s how we define an equity investor.  Someone who’s willing and able to take the risk of suffering the slings and arrows of the worldwide equity markets needs to think in terms of never investing grocery money, never investing money that they’re going to need in the next three years.  And once you’re able to insulate yourself with that sort of a rote procedure, it’s the first step towards becoming a true investor.

So, the clients that come to us and say, “Well, I’m not certain I’m cut out to be an equity investor,” we’re going to try to help them put aside enough cash flow for the next three years, and for some people, it’s even more than that, but that we see as a minimum, and then we’re going to try to help them understand that a plan is what allows you to get through periods like this, and some people aren’t able to do it themselves, so they hire people like us to do it.  I say that one of the best things that all of our client representatives at Fort Pitt do for me is provide insulation from the emotional waves that come over people.  I’m basically insulated from the clientele in that I’m able to sort of unemotionally, rationally go out and find businesses at reasonable prices and act when those prices are most reasonable.  The way I put it to an AP reporter earlier today was, we’re sitting in the weeds waiting for these, what we’ve been following as, very well run businesses to come to us at a price which we like.  So, we get busy when the whole world is seeming to scramble to safety.  That’s when we’re saying, “OK, here’s a series of companies that we’ve been waiting for to be able to buy at a reasonable price.  Here, we can buy this one, this one, this one’s not quite here yet.”  So, we’re sort of rationally evaluating what’s out there and deciding if these businesses, which we believe are viable and are going to grow over time, are at reasonable prices.  That’s why people pay us.  Some people just don’t have the emotional makeup to be investors, even after they’ve put three years’ worth of their savings into cash.


4. Money Manager Keeps Scared Investors From Being Stupid

Jim Lange:  Well, that’s actually what Nick Murray, the financial behaviorist, says, that one of the functions of having managed money is to stop you from doing something stupid based on your emotions.

Charlie Smith:  Exactly.

Jim Lange:  And he’s saying that even if they tie the S&P 500, that it’s still well worth the money that you pay just so you are, in effect, insulated against your own emotions, and you’ve obviously done a great job of taking people through not only the ups, but also the downs that we’ve experienced.

Charlie Smith:  Eighty percent of investors underperform the popular indexes.  So, it’s the 80/20 rule all over again, and I would say, of the portion of our outperformance that comes from our ability to view things dispassionately and clinically when the whole world is sort of off kilter, is where we add the most value.

Jim Lange:  And that’s such an important point for our listeners.  Just think about this for a second, and I’ve also read statistics about even Vanguard investors doing much worse than Vanguard.  How can that be?  It’s because they are making emotional decisions and they are selling when it feels the worst, and frankly, right now, this is one of those times.

Charlie Smith:  Right, exactly.  It’s a normal human emotion to want to be in concert with the crowd.  There’s a sense that I get as an investor that the characteristics of a successful money manager, there’s a certain antisocial character to it.  You have to be able to say, “Look, I don’t want to be part of the crowd.  I want to be an iconoclast.  I want to go out there and clinically build portfolios that perform without taking into account all the sort of emotional noise that’s out there,” because that’s the only way that you can do your job if you’re a money manager.

Jim Lange:  And I know in the past, I sometimes tell clients, “You can name any stock you want, and Charlie, off the top of his head, is going to tell you all about it, and he’s going to tell you how wonderful it is if it’s something that he likes,” and then I sometimes ask, “Well, Charlie, if it’s so wonderful, how come I don’t have any in my portfolio?”  And then you always come back and say, “Well, look at the price.”

Charlie Smith:  Right.


5. It’s Smart to Go Shopping While Things Are on Sale

Jim Lange:  And now, it seems to me that with your style, instead of punting and selling, that this is maybe your heyday, and it’s, oh boy, I get to go shopping while things are on sale.

Charlie Smith:  Yes, the week after the downgrade, I guess the downgrade was announced on a Friday night, we spent more of our cash in that week than any week this year, and we certainly didn’t spend all of our dry powder.  We probably have spent about a third of it thus far, and if we get another big step function downward in prices, we’ll be back in there again because we’ll be getting businesses that we believe are well run and are sustainable at prices which make them good investments for us.  There’re lots of companies out there that we’d love to own, but also lots of those same companies aren’t selling at prices anywhere near where we think makes them a good investment for us.  That’s really what people lose track of, and that’s really what the bubble in the latter part of the ’90s was all about.  People understood that they wanted to own good businesses, but they lost track of the fact that there’s a price at which even the very best business in the world becomes a terrible investment.  So, that disconnect is what really gets people off track in investing.  They let their emotions — this is the greed emotion, this is the other side of the coin here — run away with their behavior, and the dispassionate ability to say, “Look, this is what we think the business is worth,” and that’s an important part of the process as well.  But to dispassionately decide what a business is worth and then act when the rest of the world appears to be going haywire is where a lot of value gets added, definitely.

Jim Lange:  Let’s say the … I don’t know if there’s such a thing as an average listener, but let’s say a listener is maybe a do-it-yourselfer and what is going on is bothering them, and particularly because with this particular adjustment, it wasn’t just down and then that was it.  There was a fair amount of volatility within a relatively short period.  Does that change the picture?  What is that about?


6. Computers and Robots Dominate Trading During News Events

Charlie Smith:  Well, one characteristic of this recent decline, and it was really characteristic of the flash crash back in May of 2010, one characteristic is that the computers and the robotic traders have really I think begun to dominate in periods where there is a news event, and then it’s almost as if all of the robotic traders are trying to out quick one another, and they can drive prices in a linear fashion.  I mean, we saw 150-, 250-point moves in the space of minutes during the last couple of weeks, where you almost could say, “Well, there’s no longer any human intervention here,” and that’s what I think scares some people.  From my perspective, as someone who’s buying businesses, rather than trading blips on a screen, if I’ve got a good idea what I think a business is worth, and the market is willing to drive the price of that business down 20 to 30 percent in a few hours, that’s sort of like Christmas morning as far as I’m concerned.  But the average investor, who really doesn’t pay attention to what the business is worth and is thinking more in terms of the game of Wall Street, is thinking that the game is rigged at this point.  It’s happening way too fast.  It just really has become more of a casino at that point for the average investor, and I can understand why people are just shutting it out at that point.  They really don’t want to play anymore.  That’s because they’ve lost track of the true function of the investing process, which is to try to build capital and own real businesses rather than trading blips on a screen or pieces of paper.

Jim Lange:  I’ve heard you speak many times, obviously, and that’s one of the things that I love about your philosophy is that you are actually looking for good businesses, and when I say, “Well, what happens in the event of a terrorist event, or what happens if Greece goes bankrupt, or what happens if all these terrible things happen?”  And your answer is, “Well, what do you do?”  And I say, “Well, I go to work.”  And that’s what the businesses do.  So, if you can get these businesses, I mean, there’s nothing, let’s say, inherently different about a business today than it was less than a month ago, that the value of it would be reduced by 15 percent.

Charlie Smith:  Well, obviously, the marketplace is a discounting mechanism, and academic research has shown historically that the markets discount events typically nine to 12 months ahead, and that’s one of the big questions in the market today is, is the move we’ve seen since late July discounting a significant decline in economic activity in the U.S.?  In the business media for the last three days, that’s the central question that keeps getting asked over and over again.  Are we going into recession?  And the decline in share prices on the major exchanges the past couple of weeks, people are beginning to believe that it may be signaling that.  Now, there’s the old saying that the stock market has predicted ten of the last five recessions.

Jim Lange:  I have not heard that one!

7. Collapse Like Lehman Brothers Isn’t Likely Unless Europe Stumbles

Charlie Smith:  But that’s the central question: Is the marketplace indicating that fundamentally the economic world has changed in the U.S. over the past month or so?  I don’t know the answer to that, but I have some ideas about where evaluations are, and if we are going into recession, how severe it might be and where prices are relative to a severe recession, a moderate recession and a minor recession, and I think that prices today are discounting a minor to moderate recession, and the only way we’re going to get a really severe recession from here, because we’ve already seen a very meek and minor recovery, so we’ve seen the collapse in the economy and recovered only in a minor way.  I don’t believe we’re going to see a large collapse from here because we’ve always been sort of trolling along the bottom for the last three years in economic terms.  So, it’s hard for me to see, given all the cash in the banks and all the cash that people are holding, it’s hard for me to see a big surprise and another collapse a la Lehman Brothers unless things go completely haywire in Europe.  And in that way, we could see the sort of financial turmoil that we saw in September and October of 2008 here in the U.S.

I really don’t have any special insight into what’s happening in Europe.  I do know that they’ve managed to kick the can down the road for five different specific times over the past 15 months there, and I think that there is the political will there, particularly in Germany, and that’s where the rubber’s going to meet the road.  If the Germans are willing to bail out the rest of Europe, they’re going to be able to continue to sort of push this problem down the road and eventually minimize it.  But if the Germans are not willing to bail out the rest of Europe at this point, it could get a little hairy, and particularly for the U.S., we could see the economy in the U.S. in recession for maybe six months to another year.  I think the odds on that are probably less than one in five.  They’re up from one in ten maybe ten days ago, but they’re still only one in five.  So, that’s my thinking on the potential for recession here.  We may see a minor recession here.  Europe continues to kick the can.  Economic growth in the U.S. goes in a small way negative over the next six months, but it’s not going to look that much different for the average unemployed person or the average business person, particularly small business, because we’ve never recovered.

Jim Lange:  Well, let’s talk about that for a little bit.  You mentioned deficits and unemployment.  Is the biggest problem that we have right now the deficit that was obviously at least partially addressed with the debt ceiling, or is it unemployment or is it both, or is one a long-term and one is a short-term problem?  How would you characterize those problems and what is the impact of that on an investor?  So, let’s say you have a good job, your stocks are doing OK, maybe your neighbor doesn’t have a job, but frankly, we had a very nice recovery in terms of stock prices …

Charlie Smith:  Capital’s doing very well.  Labor’s doing very poorly.

Jim Lange:  Yeah, and I think a lot of times, people just assume, well, there’s a lot of people looking for a job, the market’s in the toilet, but that’s not necessarily the case, is it?

Charlie Smith:  I think those two issues, which have obviously been in the press so much the past couple of months, are symptoms of another problem behind the scenes, and it’s a problem that doesn’t get as much discussion as it should, and that is the fact that there is still, on the balance sheets of the U.S. financial system, a very large amount of overvalued asset, primarily residential real estate.  We never have rationalized all the overvaluation in the housing market.  We still need to see home prices decline further to get to a point where the market begins to clear.  We haven’t gotten there yet.  The banks know it.  That’s why they’re holding these gigantic amounts of reserves.  The Fed has visibly cranked a trillion and a half dollars’ worth of reserves into the banking system over the past 2½ years, and the banks aren’t lending it because they know they’ve got a loan book that still has a whole lot of holes in it.  So, that’s the core problem.  Now, we’ve tried to window dress the situation by either increasing federal deficit spending or, on the part of the Fed, increasing money creation.  Each of those has led to an increase in the debt problem, and I think that we cannot solve the problem of the deficit, or the unemployment problem, until we clear the decks of these legacy assets from the real estate bubble, and we’re not anywhere near that yet.  My guess is, we’ll see house prices 15 percent lower than they are today nationwide over the next three years.

Jim Lange:  I’ll tell you why I’m smiling right now.  It’s because the type of advice that I give, very often in the Roth IRA, retirement and estate planning arena, is very similar to what I have been saying for five years, for 10 years, sometimes even 20 years, and I’ve just heard this from you, and it’s just been kind of a steady issue that very few people talk about, and you’re saying, “Well, this is the problem.  Yes, companies have a lot of cash and the banks have a lot of cash, but they don’t want to lend it because they know that they have these problems coming up.”

Hana Haatainen-Caye:  All right, gentlemen.  We’re going to take a quick break.  When we come back, we’ll continue this conversation.  I want to remind our listeners out there that we are live tonight.  So, if you have any questions for Charlie or Jim, you can give us a call at (412) 333-9385.  We’ll be right back with Charlie Smith and Jim Lange on The Lange Money Hour.


Hana Haatainen-Caye:  Welcome back to The Lange Money Hour.  This is Hana Haatainen-Caye, and I’m here with Jim Lange and Charlie Smith, co-founder and chief investment officer at Fort Pitt Capital.

Jim Lange:  Charlie, I have another question for you that relates to asset allocation and some of the extreme volatility, and you might have some general feelings that you’ve had for the last five or 10 years, and you may or may not think that the immediate markets warrant the change.  How often do you typically recommend people take a look at their asset allocations, and just as you are, in effect, using some of your cash to buy what you perceive as very good buys, should people be thinking about getting more money into the market now just when it feels like the worst time and they are the most scared?

8. Over Time, Stocks Will Outperform Bonds

Charlie Smith:  Well, I think you have to separate the individual perspective and the market perspective, first from the individual perspective of the investor.  If you’ve basically decided that you’re able and willing emotionally to be an equity investor, you can understand the idea that, over time, a business is going to generate better returns than lending to that business.  That’s another way of saying that stocks outperform bonds over time.

Jim Lange:  And by the way, before you go on, could you just talk a little bit more about what you call the “equity premium?”

Charlie Smith:  Sure.

Jim Lange:  You know, for you, I know its second nature.

Charlie Smith:  It’s a separate concept.  It’s a little bit tough for most people.  The idea being that, in our society, we have literally millions of businesses where people go out and try to add value to their enterprise every day.  The idea that, over time, as an investor, you’re going to do better for yourself as an owner rather than a lender is the core of the equity premium.  The premium return that comes to the person who takes the risk of going into business is really what investing is all about from our perspective.  If you think about it, all the people on the Forbes 400 list of the wealthiest people in America, there isn’t a single person on that list who made their wealth by lending.  It’s all about equity ownership.  The returns to an equity position don’t happen in a nice, neat, straight line the way they do with a CD or a bond.  A CD or a bond is a very comforting proposition.  You get your interest every six months or every quarter or whatever, and you get your principle back in maturity.  But you know that the entity that issued that CD or that bond is earning a greater amount than what they’re paying you.  Otherwise, they wouldn’t be in business.

So, what we do as equity investors to capture the equity premium is make an end run around all those intermediaries, you know, the banks and the financial intermediaries out there, and go buy the entity which is generating that equity premium.  We want to own a piece of the business.  We understand that the returns are not going to happen in a nice, neat, straight line.  We understand that two or three years out of ten, we may have a negative return.  But we do know that literally the way our society is constructed, the people that take the risk of going into business, over time, earn a premium return relative to those who lend to business.  It’s that simple.  We want to capture that equity premium.  We do it in a diverse portfolio of businesses because we know that we’re not going to be able to pick two or three businesses and have every single one of them work out.  So, we build a portfolio of 25 or 30 companies, that’s 3 percent or 4 percent of the portfolio each, we want to make sure we have diversity in terms of industry, but we want to capture that equity premium, the premium return that comes to a business owner, in a fashion that our clients can sleep at night.  It’s really no more complicated than that.

Jim Lange:  Well, you make it sound kind of simple, but then the actual work and the actual choices that you make is well beyond what I think most people can reasonably do, and it’s one of the reasons why people, including me, actually turn to you.


9. What’s a Business Worth, and What’s the Future of Its Industry?

Charlie Smith:  Well, as I said a minute ago, it’s more about the emotional makeup and the ability to do what the numbers tell you to do than it is the technical ability to decide which businesses are best.  As I said before, we add more value for our customers by basically disagreeing with them and being able to do what they can’t in terms of taking the action.  My old boss, Ron Muhlenkamp, used to say we get paid more for our stomachs than our heads.  Now, we can do all the math.  We can decide what we think a business is worth, and to a certain extent, you do have to understand what the future looks like for a certain industry or business, and that certainly is a valuable skill, but in the end, you’re going to have to be able to put your money down when the price is right, and oftentimes, the price is right when the emotions are all wrong.  So, I think there’s more value added there than anywhere else.

Jim Lange:  Are there times that you think that there is a reaction to the market and it goes down and that maybe the market is right and it’s going to go down even further and it isn’t a good time to get in?

Charlie Smith:  That’s when we get back to your other question about the asset allocation issue.  If you’re a young person (by ‘young’ person, I’m saying 25, 30, 35, 40 years old) and you’ve got basically a 30- or 40-year investment horizon, the idea that you’re going to own a portfolio of businesses for 20 years or 25 years should lead you to believe that it doesn’t matter how much stocks decline in any given year, 20 percent, 30 percent, because 30 years from now, assuming that Democratic capitalism is still functioning in the U.S., it’s not going to matter what fluctuations, and, in fact, it’s going to benefit you if you can put some money to work when the prices decline the most.  So, the asset allocation decision you asked about before, from my perspective, for anybody who’s under 50 years old, because they have at least a 10-, 12-, 15-year horizon, should own stocks.  And I don’t really necessarily care what the day-to-day or month-to-month, or even year-to-year, fluctuations are, and in fact, if I do care, I should care in terms of wanting to add to my portfolio when the prices have fallen.

Jim Lange:  And I think here is the conundrum, particularly for people … and I’ll even go a little bit beyond people in their 30s, 40s, and 50s, even people in their 60s and 70s, you know, let’s say that you’re 65 years old and you’re retired.  Well, you’re not going to die tomorrow, and if you become too conservative, then you’re almost inevitably going to lose … and we haven’t talked about inflation and what you think the prospects of a, let’s say, significant inflation are going to be, and that’s probably worth bringing up.  I’m certainly interested.  I know Larry Kotlikoff, who is an economist at Boston University and was on earlier, and he was saying, “Hey, you know, we have all this debt, and there isn’t really a stomach for increasing taxes,” and right now, he doesn’t see enormous tax revenues flowing into the government and he doesn’t see the enormous cuts that need to be made, so he’s saying, “Hey, we’re going to have to print some money, and when we do that, we’re going to get an inflation.”

Charlie Smith:  Well, we’re doing that already.  We haven’t had inflation because the banks aren’t lending the money that’s been created.  Inflation is a function of credit growth, and the top 25 banks that account for 85 percent of the lending that goes on in this country, you look at their balance sheets, their lending loans and lease lines of their balance sheets is 10 percent smaller today than it was in September of 2008.  So, over three years, balance sheets at the banks are 10 percent smaller.  We don’t have inflation because the mechanism for transmitting that inflation into the system, i.e. credit growth, is not functioning, and my guess is that we’re not going to see any inflation until we get that system functioning again, and there’s really no sign that it’s going to be.

So, we see in the press over and over and we hear on advertisements on radio and television for gold because the hyperinflation is coming and there are lots of websites out there saying that next year, we’re going to have this calamitous event in the U.S. that’s just going to wreck the economy.  That is the scenario that says we’re going to have this hyperinflation.  There’s going to be so much money created, it’s going to get cranked into the system, and before you know it, we’re going to have inflation running at 20 percent a year and people will be having to bring their wheelbarrows to the grocery store.  That’s the 1,000 percent a year, the 1,000 percent a day scenario.  That scenario is one that people always bring up, but it’s nowhere near eventuality.  It’s nowhere near reality today because the credit creation system is still broken.  The odds are much, much greater that we look like Japan where we just have this muddle along economy.  Credit creation is not happening.  The only credit that’s being created in the economy is going to government, and you just sort of muddle along with this broken economy where you just really don’t see a whole lot of growth and not a whole lot of credit creation.  That’s a long way from the hyper-inflation that all the gold bugs are talking about.

Jim Lange:  Yeah, it’s also interesting to take a look at the long-term return of gold versus stocks, where I was reading in Stocks for the Long Run by Jeremy Siegel, and I forget the exact numbers, but if you had started with a dollar in 1800, you’d just have a couple dollars today if you had invested in gold, where if you had invested in the stock market, you’d have hundreds of thousands of dollars.


10. Gold Is Not an Investment, It’s a Hedge Against Hyper-Inflation

Charlie Smith:  Sure.  Again, gold is not an investment, it is a hedge.  It is a hedge against very, very, extremely bad policy, and the extremely bad policy that allows enough credit and enough money to be created to create a hyper-inflationary environment, those policies haven’t even been suggested yet, and I would guess that if it appears as if we’re getting to the point where we’re creating enough money in the system and it’s starting to gain traction and credit growth is happening, the inflation gauges will begin to move up enough that interest rates will spike very quickly.  There won’t be any kind of a lag.  Interest rates will move up, so that it basically shuts down the credit creation engine very quickly, so that the hyper-inflation engine won’t have a chance to even really get going.

Jim Lange:  Well, that is a different perspective than you hear from a lot of people and I appreciate it.

Charlie Smith:  Well, it doesn’t sell gold.  It doesn’t sell books.

Jim Lange:  Well, that’s what a lot of people say about you, Charlie, that you’re just kind of boring and you just have some of the same basic principles that you might have had five, 10, 20 years ago!

Charlie Smith:  Jim, when the principles change, that’s when you don’t need to bring me on the show because I’m off track at that point.  The principles of investing don’t change over time, the principles of value, the principles of the equity premium, the principles of understanding that price is the single most important determinant of return.  Again, as I said, you can have the greatest business in the world, but if it sells at the wrong price, it’s a terrible investment.  So, we never forget those few things.

Jim Lange:  That’s actually important for people to know because I actually have had some people switch from their existing money manager to Fort Pitt Capital because they said that their money manager said that, “Well, we are changing some of our principles and the way that we are thinking about things,” and that that made them more nervous than the fact of what they were switching it to, just the fact that the company didn’t, in effect, have core values that they stuck with.  And I know that you have, and frankly, that’s been very profitable for your investors.

Charlie Smith:  Well, it depends what horse you’re jumping from and what horse you’re jumping to.  I said a few minutes ago that we believe in the equity premium because we believe that Democratic capitalism as practiced in the United States is still functioning reasonably well.  We could, God forbid, get to some point where I don’t believe that Democratic capitalism is going to still function reasonably well in this country.  Some people believe that the S&P downgrade of U.S. debt is a sort of lightning flash of the approaching storm in that regard, that we’re off-track and we’re not functioning properly anymore.  I don’t necessarily agree with that, but the point is, if we begin to believe that our system had gone so far off the rails that this apocalyptic vision of hyper-inflation or hyper-deflation or a chaotic economy, where we were pushing back towards agrarianism and we had really gone off the track.  If I believe that we had to adjust our portfolios to deal with that scenario as a real probability, I would do it.  So, anybody who’s changing their MO, so to speak, you have to evaluate why they’re doing it, but if they can come up with a very good rationale as to why, you need to listen to them.  I’m not saying that we’re in a static state that’s always going to be a positive for capitalism here in this country.  If the rules change and we get the wrong policies in place, we could take this country off the rails.  I don’t think we’re anywhere near there yet, but it could happen.

Jim Lange:  All right.  So, is it fair to say, in terms of one of the things I said that we would try to do on this show is to tell investors what to do?  And let’s take two possible scenarios.  One is the investor who is a committed equity investor, has a well-diversified portfolio, has some money outside of the equity investments in order to spend.  People have different amounts of cash, but let’s even use your number of three years’ cash, and let’s assume a relatively long time horizon.  Should that person more or less stay put or even look for opportunities?

Charlie Smith:  As long as they’re not going to be eating into the amount of cash that allows them to sleep at night, because they don’t know that over the next six weeks, we might not see another 20 percent decline, at which point, they might feel like they would change their behavior, and again, at exactly the wrong time.  So, even a person as you just described, who, from my perspective, should be in pretty good shape, they’ve got some cash set aside, they’ve got a perspective, which says, OK, I understand that a 15 percent to 20 percent decline is not all that unusual, that person needs to know that if things get really hairy, they’re not going to want to change their behavior at that point, and it really is hard to know until you get to that point.  People talk a good game in that area, but in February and March of 2009, when we had customers coming to us and saying that Barack Obama was purposely wrecking the economy and our society, purposely as the president of the United States, our clients came to us and said that.  That perspective, it was if it had come from another planet as far as I was concerned, but the point being that if you’re going to begin thinking that way, or there’s a possibility that you might begin thinking that way, maybe you need five years’ worth of cash, because if you begin to think that way, you’re going to be acting that way at the wrong time.  So, even the most hard-bitten investor, the person who feels he’s steeled him or herself against a change in the economy or the markets, needs to try to put themselves in the mindset that they might be in if we get another 20 percent decline from here, and if there’s any chance that you’re going to want to change things if that happens, you probably need to change it now.  See what I’m saying?

Jim Lange:  All right.  That brings up one other issue that has always kind of puzzled me, and I’m wondering how you, as a money manager, would handle it, and that is, a lot of times, people will come to you with, let’s say, a certain amount of money to invest, but they have other financial resources, and specifically income resources.  The two big ones and the obvious ones are Social Security and pensions.  So, let’s say that there’s two people with — to use a round number, a million-dollar portfolio, or even a half-million-dollar portfolio — and one of them has, let’s say, a relatively meager Social Security and the other one has a more generous Social Security in addition to a pension.  Will the portfolios of those two people look similar in a Fort Pitt portfolio, or would you say, “Well, since you, in effect, have a certain guaranteed base with your pension and your Social Security, we can afford to think of you as a longer-term investor because you have a certain cash flow that can satisfy short-term cash flow needs.”


11. Security, Pension Benefits Make Up Fixed Income Portfolio

Charlie Smith:  Exactly, yeah.  We think of the Social Security asset and the pension as their fixed income portfolio.  It’s basically a bond portfolio at that point.

Hana Haatainen-Caye:  OK, we’re going to take another break now, and again, I just want to remind you that you can call in at (412) 333-9385 to speak with Charlie Smith or Jim Lange, and we’ll be right back.


Hana Haatainen-Caye:  Welcome back to The Lange Money Hour.  This is Hana Haatainen-Caye, and I’m here with Jim Lange and Charlie Smith, co-founder and chief investment officer at Fort Pitt Capital.

Jim Lange:  And I just want to remind listeners, so there is no charge of lack of disclosure, that I and my wife do have our money invested at Fort Pitt Capital.  I do have a business relationship with them whereby I make strategic recommendations and they actually manage the money for a fee of one percent or less, depending on how much money you have under management.  Charlie, one of the things that I was going to ask is, traditionally, in our respective roles, because you do certain things for clients, and one of the things that we do is Roth IRA conversions and making Roth IRA conversions, and maybe at a different time, I could talk about some of the short-term impacts of markets and the issue of making Roth IRA conversions.  But I know one of the things that your office has traditionally done, and you’ve done it beautifully for a lot of our clients, is you do tax loss harvesting.

Charlie Smith:  Sure.

Jim Lange:  Could you tell our listeners what you’re thinking about tax-loss harvesting is, maybe in general, and people do have some winners now.  You know, we sometimes forget how much the market— and you specifically — have done, say, in 2009, what some of the implications are in terms of what you are doing with tax-loss harvesting, or whether you’re waiting for the end of the year, or whether that’s a case-by-case basis?

Charlie Smith:  Well, typically, we will do our loss harvesting …

Jim Lange:  And maybe we should talk for a minute about what is tax-loss harvesting, too.


12. To Offset Gains, Search Portfolio to Balance With Losses

Charlie Smith:  Sure, certainly.  If you’re a taxpaying investor, you’re managing money that’s not an IRA or 401(K) or a pension plan or a profit-sharing plan, and you take a gain, you’re going to pay a 15 percent rate on a long-term capital gain.  And so, if in your portfolio, some stocks are going to do well, some are not, hopefully, the number of ones that don’t do well is as small as possible, but in any case, in any given year, you’re going to have gains and losses.  What we do at Fort Pitt Capital, and most well-run money managers will do the same thing, is go in, typically in the early part of the fourth quarter, and say, “OK, these are the gains we’ve taken thus far, and we’ve had some gains,” as you mentioned.  In fact, over the last two years, we’ve used up a lot of the previous losses from the previous cycle, but at this point now, let’s say we’ve got a portfolio that’s worth a million dollars, and we’ve got $80,000 in gains that we’ve taken in the first seven months of the year.  We will scour the portfolio for losses in businesses that either we think have a lessened potential for appreciation, or even in some cases businesses that we want to own for the long-term and we will eventually buy back at some point, we will scour the portfolio for losses to offset the gains so that we don’t have you paying any taxes come April 15th of next year.  We will also take losses up to, I believe, it’s $3,000 or so on an annual basis that you can offset against your regular income.  I think it’s more than $3,000 today.  It’s been bumped up, but somewhere in the $3,000 to $4,000 range.  So, you can use some of those losses if you have them against some of your ordinary income as well.

So, what we’ll try to do is be sure that we defer any taxes out as far as we can do it.  We like to tell our customers, ideally, over the long-term, you will pay millions of dollars in long-term capital gain taxes.  Ideally, you’ll never pay any taxes, and that’s really an interesting issue with what Warren Buffett was in the New York Times talking about earlier this week.  But the point being that we want to try to defer those gains, and where we’ve taken the gains recently, we want to offset them the best we can with existing losses.

Jim Lange:  And is it fair to say that you usually do that towards the fourth quarter?

Charlie Smith:  Yeah, because if we’re taking gains earlier in the year and they’ve built up, we want to make sure we get it done before December 31st.

Jim Lange:  And on my end, with the Roth IRA conversion issues, what we are doing, in fact, I was doing this today, I was taking a look at … and we try to cover all our clients that we know made Roth IRA conversions, is we try to get an idea of what the value of the stock or investment was on the day of the conversion and then was it is now.  And if we do have a situation, the reason why this is a busy time for us is that we are taking a look to see if people lost money, and if they did and they had made a conversion, what we are sometimes doing is we are recommending that people recharacterize, or un-convert, which is an interesting concept, and what we have actually found is even though we expected there to be big losses, we sometimes found that at the time that we were making the Roth conversion recommendation back in 2010, that even though the market’s down right now, it was lower when they made the conversion.  So, often, again, you know, you do a bunch of work and you look through it, and then the conclusion is to do nothing.

Charlie Smith:  Right, sure, and that’s most of the time in our portfolios.  I would say, in a typical, you know, we’ve got a couple thousand portfolios, and probably 40 percent of those are taxable, in a given year, we’ll probably see three or four transactions that are tax loss-related, and some people come to us with very, very large loss carry forwards, and that’s something we keep track of.  We send out a letter once a year to our customers saying, “Look, you need to let us know if you’ve got transactions outside of what we see.  Do you have a loss carry forward?”  We want to make sure that we’ve got all the information we need to do the proper tax planning in the portfolio.

Jim Lange:  Right, but then sometimes the right action is to do nothing.

Charlie Smith:  Many times, it is.

Jim Lange:  And I remember, actually, one of the questions that was addressed to you, I think, in one of your client appreciation events, somebody said, “Well, does that mean if you buy something and you don’t do anything that we pay you 1 percent just to look at it and do nothing?”  And you smiled and said, “Yup!”

Charlie Smith:  Right, yeah!  I have a little plaque on my wall that says “Don’t just do something.  Stand there.”  Because the idea is you put together a portfolio of well-run businesses that you expect to own three, five, eight, 10 years, and let it work.  Now, about a third of the time, the names we put in the portfolio aren’t going to do what we expect.  That’s where we need to go in and make a change.  But in the real world, and our portfolio’s a perfect example, we have an average holding period of about eight years in the positions we own.  So, yeah, there’s going to be a whole lotta time where once you get the portfolio built — and it takes us typically about 10 months to build a portfolio from cash — it’s mostly just sort of letting it work.  My old boss, my other old boss, Bill Few at Bill Few Associates, used to say, “An investment portfolio’s like a bar of soap.  The more you play with it, the smaller it’s going to get.”  So, the idea being let the managements that you’ve bought, the businesses that you’ve bought, let them work.  The places where you’ve made a mistake, go back in and fix it, but generally, just let the system work for you.  Don’t play with it, because it’s going to get smaller if you do.

Jim Lange:  Yeah, and by the way, to me, it’s a testament of your philosophy and the way that you do business that your average holding period is eight years.  I don’t think very many money managers or any type of investment house could make that claim.

Charlie Smith:  The typical mutual fund turns its portfolio 100 percent per year.  That’s not investing.

Jim Lange:  All right, and whether they’re right or whether they’re wrong, they’re going to be adding so much cost that it’s just going to really hurt the investor.

Charlie Smith:  Yes, exactly.  Trading is cheaper than it used to be, but it’s still expensive, and the amount of work and effort…I work my tail off to try to find four or five good new investments a year.  If you’ve got a portfolio with 50 or 100 companies in it and it’s turning over 100 percent a year, I don’t know how you find the time to find 50 good new businesses every year.  We try to find four or five, and it’s hard work.

Hana Haatainen-Caye:  Thank you for joining us for another episode of The Lange Money Hour.  We hope we were able to calm some of those nerves the market is so good at rattling.  I want to thank Charlie for being here tonight, and we want to leave you with a quote from Warren Buffett: “Look at market fluctuations as your friend rather than your enemy.  Profit from folly rather than participate in it.”